The vicious circle of cutting prices

In the last week, two major British supermarkets announced significant price cutting strategies.  First, Asda announced a major price cutting exercise aimed at gaining market share.  A couple of days later, Morrison’s announced price cuts to 1000 product lines.  Morrison’s announcement was smaller in scale to that of Asda; most supermarkets carry between 10,000 and 15,000 products; but it was clearly as response to Asda’s change of strategy.

Both Asda and Morrison’s have been hard hit by the rise of discount chains such as Aldi.  Asda are clearly trying to claw back some market share they have lost to the discounters in recent years.  However, cutting prices as part of a market penetration strategy (as expressed in the Ansoff Matrix) is a risky approach to business and it may lead to a vicious business cycle.  In fact, one prominent marketing has been quoted as saying, “only a fool cuts prices to chase market share”.  The reason is that cutting prices may result in a downward spiral in relation to profit margins.

The vicious circle operates as follows:

  1. You cut prices to increase your customer numbers.
  2. You sell more but at lower margins i.e. number of sales goes up but revenue flat lines or even falls.
  3. Your competitors cut their prices ( a price-war starts)
  4. Stagnating revenues cause you to cut costs and to lower the standard of your offer e.g. you don’t update store decor or you reduce consumer choice.
  5. You lose customers
  6. The loss of revenues from lower sales mean you have to cut prices and the circle renews.

It is incredibly difficult to cut your prices and retain your level of profit margin.  If you want to maintain a 10% gross profit margin with a price cut of 3% you need to increase sales by 42%.  A 42% rise in sales is a massive increase in market share.

Having visited my local Asda recently, I found an ageing store with narrow aisles stuffed full of produce.  The choice of goods on offer was limited.  The store resembled a cramped warehouse rather than a place for an enjoyable retail experience.  Rather than a leisurely pursuit, shopping at Asda was a chore.  it would be interesting to see how long consumers stay in the store; or whether they rush through their shopping.

In fact a price cutting strategy may do more harm than raising your prices.  Raising prices may result in a benign circle as follows:

  1. You raise prices
  2. You sell less but at a higher profit margin
  3. You invest the increase in margin in improving your marketing offer e.g. improving customer choice and quality of service
  4. Customers accept the higher price as they feel it offers better value given the increase in quality and service
  5. Sales volumes and market share increase
  6. You have the option of raising prices.

The benign circle is an example of a ‘more for more’ strategy where prices can be raised because consumers see your bundle of service and product quality as better value than cheaper alternatives.

For example Barbour jackets are not cheap BUT, they last for decades and are easily maintained. They have therefore become a favourite of the country set who are willing to pay a price premium in the knowledge they are buying a quality product.

BMW sell their cars at a price premium but consumers accept that price premium as the cars are seen as high quality and technologically advanced.

Of course, what most businesses want is a virtuous circle where both profit margins and market share are maximised.  This is an incredibly difficult thing to achieve.  One solution might be:

  1.  Hold prices
  2. Accept your market share position
  3. Invest to improve products and levels of service. Improve your market offer.
  4. Increase your customer base and market share.
  5. Hold prices.

In some respects, this is what Aldi have done. Recognising they were garnering an increasing middle class customer segment, Aldi held their prices but increased their product choice and improved the appearance of their stores.  They based their advertising not just on the fact that their prices were lower than branded equivalents but that the quality of products were equivalent if not better.  The result was an increase in customer footfall and a greater share of the supermarket sector.

Remember, Professor Malcolm Macdonald has carried out study after study of retail markets and found that only about 7% of consumers focus on price.  A price cutting strategy may be attractive to that customer segment but it may have a neutral or detrimental effect on the remaining 93% of consumers.

One of Professor Macdonald’s studies was carried out for ICI’s fertilizer division.  ICI segmented farmers into seven groups and designed sales tactics for each of those seven groups.  ICI’s competitors were wholly focused on marketing their products to farmers solely on the basis of price.  By focusing on the individual needs of different segments, not just price, ICI significantly increased their share of the fertilizer market.  Price cuts alone are no guarantee of increased market share.